1. Chapter 10 Partnerships: Formation, Operation, and Basis
Corporations, Partnerships,
Estates & Trusts
Copyright ©2008 South-Western/Thomson Learning

2. Partnership Definition
An association of two or more persons to carry on a trade or business
Contribute money, property, labor
Expect to share in profit and losses
For tax purposes, includes:
Syndicate
Group
Pool
Joint venture, etc

3. Entities Taxed as Partnerships (slide 1 of 4)
General partnership
Consists of at least 2 partners
Partners are jointly and severally liable
Creditors can collect from both partnership and partners’ personal assets
General partner’s assets are at risk for malpractice of other partners even though not personally involved

4. Entities Taxed as Partnerships (slide 2 of 4)
Limited liability partnership (LLP)
An LLP partner is not personally liable for malpractice committed by other partners
Popular organizational form for large accounting firms

5. Entities Taxed as Partnerships (slide 3 of 4)
Limited partnership
Has at least one general partner
One or more limited partners
Only general partner(s) are personally liable to creditors
Limited partners’ loss is limited to equity investment

6. Entities Taxed as Partnerships (slide 4 of 4)
Limited liability company (LLC)
Combines the corporate benefit of limited liability with benefits of partnership taxation
Unlike corporations, income is subject to tax only once
Special allocations of income, losses, and cash flow are available
Owners are “members,” not partners, but if properly structured will receive partnership tax treatment

7. “Check-The-Box” Regs (slide 1 of 2)
Allows most unincorporated entities to select their federal tax status
If 2 or more owners, can choose to be treated as:
Partnership, or
Corporation
Permits some flexibility
Not all entities have a choice
e.g., New publicly traded partnerships must be taxed as corporations

8. “Check-The-Box” Regs (slide 2 of 2)
Some entities can be excluded from partnership treatment if organized for:
Investment (not active trade or business)
Joint production, extraction, or use of property
Underwriting, selling, or distributing a specific security
Owners simply report their share of operations on their own tax return

9. Partnership Taxation (slide 1 of 3)
Partnership is not a taxable entity
Flow through entity
Income taxed to owners, not entity
Partners report their share of partnership income or loss on their own tax return

10. Partnership Taxation (slide 2 of 3)
Generally, the calculation of partnership income is a 2-step approach
Step 1: Net ordinary income and expenses related to the trade or business of the partnership
Step 2: Segregate and report separately some partnership items
If an item of income, expense, gain or loss might affect any 2 partners’ tax liabilities differently, it is separately stated
e.g., Charitable contributions

11. Partnership Taxation (slide 3 of 3)
Electing large partnerships can net some items that would otherwise be separately stated
Must have at least 100 partners and elect simplified reporting procedures
Report no more than 16 separately stated items
e.g., Combine interest, nonqualifying dividends, and royalty income into one amount, and report the net amount to partners

12. Partnership Reporting
Partnership files Form 1065
Includes Schedule K which accumulates the information to be reported to partners
Provides ordinary income and separately stated items in total
Each partner (and the IRS) receives a Schedule K-1
Reports each partner’s share of income, expense, gain, and loss

13. Partner’s Ownership Interest
Each owner normally has a:
Capital interest
Measured by capital sharing ratio
Partner’s percentage ownership of capital
Profits (loss) interest
Partner’s % allocation of partnership ordinary income (loss) and separately stated items
Certain items may be “specially allocated”
Specified in the partnership agreement

14. Basis Issues (slide 1 of 3)
Each partner has a basis in their partnership interest
Partner’s basis is adjusted for income and losses that flow through
This ensures that partnership income is only taxed once

15. Basis Issues (slide 2 of 3)
Partner’s basis is important for determining:
Deductibility of partnership losses
Tax treatment of partnership distributions
Calculating gain or loss on the partner’s disposition of the partnership interest

16. Basis Issues (slide 3 of 3)
Partner’s capital account balance is usually not a good measure of a partner’s adjusted basis in a partnership interest for several reasons
e.g., Basis includes partner’s share of partnership liabilities; Capital account does not

17. Conceptual Basis for Partnership Taxation (slide 1 of 2)
Involves 2 legal concepts:
Aggregate (or conduit) concept—Treats partnership as a channel with income, expense, gains, etc. flowing through to partners
Concept is reflected by the imposition of tax on the partners, not the partnership

18. Conceptual Basis for Partnership Taxation (slide 2 of 2)
Involves 2 legal concepts (cont’d):
Entity concept—Treats partners and partnerships as separate and is reflected by:
Partnership requirement to file its own information return
Treating partners as separate from the partnership in certain transactions between the two

19. Partnership Formation Transaction
Cash or Other Property
Partnership Interest

20. Tax Consequences of Partnership Formation (slide 1 of 2)
Usually, no gain or loss is recognized by a partner or partnership on the contribution of money or property in exchange for a partnership interest
Gain (loss) is deferred until taxable disposition of:
Property by partnership, or
Partnership interest by partner

21. Tax Consequences of Partnership Formation (slide 2 of 2)
Partner’s basis in partnership interest = basis of contributed property
If partner contributes capital assets and §1231 assets, holding period of partnership interest includes holding period of assets contributed
For other assets including cash, holding period begins on date partnership interest is acquired
If multiple assets are contributed, partnership interest is apportioned and separate holding period applies to each portion

22. WST Partnership Formation Example (slide 1 of 2)
William contributes cash
Amount $20,000
Sarah contributes land
Basis $ 6,000
FMV $20,000
Todd contributes equipment
Basis $22,000

23. WST Partnership Formation Example (slide 2 of 2)
Gain or loss Basis in Partnership’s
Partner Recognized Interest Property Basis
William $-0- $20, $20,000
Sarah $-0- $ 6, $ 6,000
Todd $-0- $22, $22,000
Neither the partnership nor any of the partners recognizes gain or loss on the transaction

24. Exceptions to Tax-Free Treatment on Partnership Formation (slide 1 of 4)
Transfers of appreciated stock to investment partnership
Gain will be recognized by contributing partner
Prevents multiple investors from diversifying their portfolios tax-free

25. Exceptions to Tax-Free Treatment on Partnership Formation (slide 2 of 4)
If transaction is essentially a taxable exchange of properties, gain will be recognized
e.g., Individual A contributes land and Individual B contributes equipment to a new partnership; shortly thereafter, the partnership distributes the land to B and the equipment to A; Partnership liquidates
IRS will disregard transfer to partnership and treat as taxable exchange between A & B

26. Exceptions to Tax-Free Treatment on Partnership Formation (slide 3 of 4)
Disguised Sale
e.g., Partner contributes property to a partnership; Shortly thereafter, partner receives a distribution from the partnership
Payment may be viewed as a purchase of the property by the partnership

27. Exceptions to Tax-Free Treatment on Partnership Formation (slide 4 of 4)
Receipt of partnership interest in exchange for services rendered to partnership
Services are not treated as “property”
Partner recognizes ordinary compensation income = FMV of partnership interest received

28. Tax Issues Relative to Contributed Property (slide 1 of 3)
Contributions of depreciable property and intangible assets
Partnership “steps into shoes” of contributing partner
Continues the same cost recovery and amortization calculations
Cannot expense contributed depreciable property under §179

29. Tax Issues Relative to Contributed Property (slide 2 of 3)
Gain or loss is ordinary when partnership disposes of:
Contributed unrealized receivables
Contributed property that was inventory in contributor’s hands, if disposed of within 5 years of contribution
Inventory includes all tangible property except capital assets and real or depreciable business assets

30. Tax Issues Relative to Contributed Property (slide 3 of 3)
If contributed property is disposed of at a loss and the property had a ‘‘built-in’’ capital loss on the contribution date
Loss is treated as a capital loss if disposed of within 5 years of the contribution
Capital loss is limited to amount of ‘‘built-in’’ loss on date of contribution

31. Inside and Outside Bases
Inside basis
Refers to adjusted basis of each partnership asset
Each partner “owns” a share of the partnership’s inside basis for all its assets
Outside basis
Represents each partner’s basis in the partnership interest
All partners should maintain a record of their respective outside bases

32. Elections Made by Partnership (slide 1 of 2)
Inventory method
Accounting method
Cash, accrual or hybrid
Depreciation method
Tax year
Organizational cost amortization
Start-up expense amortization

33. Elections Made by Partnership (slide 2 of 2)
Optional basis adjustment (§754)
§179 deduction
Nonrecognition treatment for involuntary conversions
Election out of partnership rules

34. Organizational Costs (slide 1 of 2)
For organization costs incurred after October 22, 2004, the partnership may elect to deduct up to $5,000 of the costs in year business begins
This amount must be reduced by organization costs that exceed $50,000
Remaining amounts are amortizable over 180 months beginning with month the partnership begins business
For organization costs incurred before that date, the taxpayer could elect to amortize the amount over 60 months

35. Organizational Costs (slide 2 of 2)
Organizational costs include costs:
Incident to creation of the partnership, chargeable to a capital account, and of a character that, if incident to the creation of a partnership with an ascertainable life, would be amortized over that life
Includes accounting fees and legal fees connected with the partnership’s formation
Costs incurred for the following items are not organization costs:
Acquiring and transferring assets to the partnership
Admitting and removing partners, other than at formation
Negotiating operating contracts
Syndication costs

36. Start-up Costs (slide 1 of 2)
Start-up costs—include operating costs incurred after entity is formed but before it begins business including:
Marketing surveys prior to conducting business
Pre-operating advertising expenses
Costs of establishing an accounting system
Costs incurred to train employees before business begins, and
Salaries paid to executives and employees before the start of business

37. Start-up Costs (slide 2 of 2)
Partnership may elect to deduct up to $5,000 of start-up costs in the year it begins business
Amount must be reduced by start-up costs in excess of $50,000
Costs that are not deductible under this provision are amortizable over 180 months beginning with the month in which the partnership begins business
For start-up costs incurred before October 23, 2004, the taxpayer could elect to amortize those costs over 60 months

38. Method of Accounting (slide 1 of 2)
New partnership may adopt cash, accrual or hybrid method
Cash method cannot be adopted if partnership:
Has one or more C corporation partners
Is a tax shelter

39. Method of Accounting (slide 2 of 2)
New partnership may adopt cash, accrual or hybrid method (cont’d)
C Corp partner does not preclude use of cash method if:
Partnership has average annual gross receipts of $5 million or less for preceding 3 year period
C corp partner(s) is a qualified personal service corp, or
Partnership is engaged in farming business

40. Required Taxable Year
Partnership must adopt tax year under earliest of following tests met:
Majority partner’s tax year (partners with same tax year owning >50%)
Principal partners’ tax year (all partners owning 5% or more)
Least aggregate deferral rule

41. Least Aggregate Deferral Example (slide 1 of 2)
George owns 50% and has June 30 year end
Henry owns 50% and has October 31 year end
Neither partner owns a “majority” (>50%)
Both are “principal partners” (5% or more), but do not have same year end
Must use least aggregate deferral test to determine required taxable year

42. Least Aggregate Deferral Example (slide 2 of 2)
1. Test June 30 as possible year end:
Partner. Year End % Mo. Deferral Weight
George June 50%
Henry October 50%
Total weighted deferral
2. Test October 31 as possible year end:
George June 50%
Henry October 50%
Total weighted deferral
June has the least aggregate deferral so it is the tax year for partnership.

43. Alternative Tax Years Other alternatives may be available if:
Establish to IRS’s satisfaction that a business purpose exists for another tax year
e.g., Natural business year at end of peak season
Choose tax year with no more than 3 month deferral
Partnership must maintain with the IRS a prepaid, non-interest-bearing deposit of estimated deferred taxes
• Elect a 52- to 53-week taxable year

44. Measuring Income of Partnership
Calculation of partnership income is a 2-step approach
Step 1: Net ordinary income and expenses related to the trade or business of the partnership
Step 2: Segregate and report separately some partnership items

45. Separately Stated Items (slide 1 of 2)
If an item of income, expense, gain or loss might affect any 2 partners’ tax liabilities differently, it is separately stated

46. Separately Stated Items (slide 2 of 2)
Separately stated items fall under the “aggregate” concept
Each partner owns a specific share of each item of partnership income, gain, loss or deduction
Character is determined at partnership level
Taxation is determined at partner level

47. Examples of Separately Stated Items (slide 1 of 2)
Short and long-term capital gains and losses
§1231 gains and losses
Domestic production activities deduction
Charitable contributions
Interest income and other portfolio income
Expenses related to portfolio income

48. Examples of Separately Stated Items (slide 2 of 2)
Personalty expensed under §179
Special allocations of income or expense
AMT preference and adjustment items
Passive activity items
Self-employment income
Foreign taxes paid

49. Partnership Taxable Income Example (slide 1 of 3)
Sales revenue $100,000
Salaries ,000
Rent ,000
Utilities ,000
Interest income ,500
Charitable contribution ,000
AMT adjustment for depreciation ,600
Payment of partner’s medical expenses ,000

50. Partnership Taxable Income Example (slide 2 of 3)
Partnership ordinary taxable income:
Sales revenue $100,000
Salaries ,000
Rent ,000
Utilities ,000
Partnership Ordinary Income $ 44,000

51. Partnership Taxable Income Example (slide 3 of 3)
Separately stated items:
Interest income $1,500
Charitable contribution ,000
AMT adjustment for depreciation ,600
Distribution to partner:
Payment of partner’s medical exp $4,000

52. Partnership Allocations (slide 1 of 3)
Partnership agreement can provide that a partner share capital, profits, and losses in different ratios
e.g., Partnership agreement may provide that a partner has a 30% capital sharing ratio, yet be allocated 40% of the profits and 20% of the losses
Such special allocations are permissible if certain rules are followed
e.g., Economic effect test

53. Partnership Allocations (slide 2 of 3)
The economic effect test requires that:
An allocation must be reflected in a partner’s capital account
When partner’s interest is liquidated, partner must receive assets with FMV = the positive balance in the capital account
A partner with a negative capital account must restore that account upon liquidation

54. Partnership Allocations (slide 3 of 3)
Precontribution gain or loss
Must be allocated to partners taking into account the difference between basis and FMV of property on date of contribution
For nondepreciable property this means any built-in gain or loss must be allocated to the contributing partner when disposed of by partnership in taxable transaction

55. Basis of Partnership Interest (slide 1 of 3)
For new partnerships, partner’s basis usually equals:
Adjusted basis of property contributed, plus
FMV of any services performed by partner in exchange for partnership interest

56. Basis of Partnership Interest (slide 2 of 3)
For existing partnerships, basis depends on how interest was acquired
If purchased from another partner, basis = amount paid for the interest
If acquired by gift, basis = donor’s basis plus, in certain cases, a portion of the gift tax paid on the transfer
If acquired through inheritance, basis = FMV on date of death (or alternate valuation date)

57. Basis of Partnership Interest (slide 3 of 3)
A partner’s basis in partnership interest is adjusted to reflect partnership activity
This prevents double taxation of partnership income

58. Basis Example (slide 1 of 2)
Pam is a 30% partner in the PDQ partnership
Pam’s beginning basis is $20,000
PDQ reports current income of $50,000
Pam sells her interest for $35,000 at the end of the year

59. Basis Example (slide 2 of 2)
With Basis Without Basis
Adjustment Adjustment
Selling Price(A) $ 35, $35,000
Less: Basis in interest
Beginning basis , ,000
Share of current income 15,
Ending basis (B) , ,000
Taxable gain (A)-(B) $ $15,000
–If no basis adjustment, Pam's $15,000 share of partnership income is taxed twice: as ordinary income and as gain on sale of interest

60. Adjustments to Basis Initial Basis
+ Partner’s subsequent contributions to partnership
+ Partner’s share of partnership:
Debt increase
Income items
Exempt income items
Depletion adjustment
– Distributions and withdrawals from partnership
– Partner’s share of partnership:
Debt decreases
Nondeductible expenses
Deductions and losses

61. Basis Limitation
A partner’s basis in the partnership interest can never be negative

62. Partnership Liabilities
Affect partner’s adjusted basis
Increase in partner’s share of liabilities
Treated as a cash contribution to the partnership
Increases partner’s adjusted basis
Decrease in partner’s share of liabilities
Treated as a cash distribution to the partner
Decreases partner’s adjusted basis

63. Allocation of Partnership Liabilities
Two types of partnership debt
Recourse debt—At least one partner is personally liable
Allocate to partners using a “Constructive Liquidation Scenario”
Nonrecourse debt—No partner is personally liable
Allocate to partners using a three-tiered allocation

64. Constructive Liquidation Scenario
1. Partnership assets deemed to be worthless
2. Assets deemed sold at $0; losses determined
3. Losses allocated to partners under partnership agreement
4. Partners with negative capital accounts deemed to contribute cash
5. Deemed contributed cash would repay partnership debt
6. Partnership deemed to liquidate
- Partner’s share of recourse debt = Cash contribution
used to repay debt (Step 5)

65. Nonrecourse Debt Allocation
Three step allocation:
1. “Minimum Gain” allocated under regulations
Minimum gain is basically gain which would arise on foreclosure of property
2. Liability = precontribution gain allocated to contributing partner
3. Remaining debt commonly allocated by profit sharing ratios (other allocation methods could be used)

66. Loss Limitations (slide 1 of 2)
Partnership losses flow through to partners for use on their tax returns
Amount and nature of losses that may be used by partners may be limited
Three different loss limitations apply
Only losses that make it through all three limits are deductible by a partner

67. Loss Limitations (slide 2 of 2)
Section Description
704(d) Basis in partnership interest
At-risk limitation
Passive loss limitation
Limitations are applied successively to amounts which are deductible at all prior levels

68. Loss Limitation Example (slide 1 of 2)
Meg's basis in interest $50,000
At-risk amount $35,000
Passive income, other sources $25,000
Share of partnership losses(passive) $60,000

69. Loss Limitation Example (slide 2 of 2)
Provisions Deductible loss Suspended loss
704(d) $ 50, $ 10,000
, ,000
,000* ,000
*Amount deducted on tax return: $25,000
-passes all three loss limitations

70. Guaranteed Payments
Payment to partner for use of capital or for services provided to partnership
May not be determined by reference to partnership income
Usually expressed as a fixed dollar amount or as a % of capital

71. Treatment of Guaranteed Payments (slide 1 of 2)
May be deducted or capitalized by partnership depending on the nature of the payment
Deductible by partnership if meets “ordinary and necessary business expense” test
May create partnership loss

72. Treatment of Guaranteed Payments (slide 2 of 2)
Includable in income of partner at time partnership deducts
Treated as if received on last day of partnership tax year
Character is ordinary income to recipient partner

73. Other Transactions Between Partner and Partnership (slide 1 of 2)
May be treated as if partner were an outsider, for example:
Loan transactions
Rental payments
Sales of property

74. Other Transactions Between Partner and Partnership (slide 2 of 2)
Timing of deduction for payment by an accrual basis partnership to a cash basis partner depends on whether payment is:
Guaranteed payment
Included in partner’s income on last day of partnership year when accrued (even if not paid until the next year)
Payment to partner treated as an outsider
Deduction cannot be claimed until partner includes the amount in income

75. Sales of Property
No loss is recognized on the sale of property between a partnership and a partner who owns > 50% of partnership capital or profits
If property is subsequently sold at a gain, the disallowed loss reduces gain recognized

76. Partners as Employees
A partner usually does not qualify as an employee for tax purpose resulting in the following tax consequences:
A partner receiving guaranteed payments from the partnership is not subject to tax withholding
The partnership cannot deduct payments for a partner’s fringe benefits
A general partner’s distributive share of ordinary partnership income and guaranteed payments for services are generally subject to the Federal self-employment tax